Skip Navigation

Tax Efficiency: Not All Taxes Are Created Equal

January 1, 2007
By Jason Clements, Niels Veldhuis, and Milagros Palacios

One reason that governments impose taxes is to finance the services that citizens demand. This study examines how governments can extract tax revenues in the least costly and economically damaging manner in order to improve economic performance.

tax documents

One reason that governments impose taxes is to finance the services that citizens demand. This study examines how governments can extract tax revenues in the least costly and economically damaging manner in order to improve economic performance.

Costs of taxation

Efficiency costs
The costs associated with taxation extend far beyond the amount of tax collected. First, there are significant incentive-based costs, which are generally referred to as efficiency costs. These costs emerge because taxes alter relative prices and thus the incentives for productive behaviour and affect a wide range of decisions regarding savings, investment, effort, and entrepreneurship. These costs vary widely by the type of tax.

One main method for quantifying these costs is referred to as the marginal efficiency cost (MEC). It calculates the cost of raising one additional dollar of tax revenue using different types of taxes. Estimates of the marginal efficiency costs of both American and Canadian taxes indicate that consumption and payroll (wage and salary) taxes are much less costly (and thus more efficient) than taxes on capital or the return to capital. For example, a study by the Department of Finance for the OECD (1997) concluded that corporate income taxes imposed a marginal cost of $1.55 (MEC) for one additional dollar of revenue compared to $0.17 for an additional dollar of revenue raised through consumption taxes.

Article Tags
Taxes Government Spending